Sunday, October 7, 2012

Comparing China with Japan and Other Stories

Is it possible or relevant to compare China with Japan and if so which Japan? Should it be 1970s Japan or late 1980s Japan? While many commentators argue that China is better compared to 1970s Japan, Michael Pettis argues that China resembles 1980s Japan because of the unbalanced nature of its economy.

Japan in the late 1960s and early 1970s may share many developmental characteristics with China today, but the Japanese economy in that earlier period never achieved, as far as I can see, the kinds of imbalances that it did much later in the 1980s, and so it is not really comparable to an extremely unbalanced China today.

These imbalances are well documented. The important characteristics of Japan in the late 1980s would almost certainly include the following:

Japan in the late 1980s grew at extraordinary rates fueled by a credit-backed investment boom funded at artificially low interest rates.

Although for many decades much of the investment may have been viable and necessary, by the 1980s investment was increasingly misallocated into expanding unnecessary manufacturing capacity, as well as fueling surges in real estate development and excess spending on infrastructure.

Artificially low rates, set nominally by the central bank but in reality by the Ministry of Finance, and coming mainly at the expense of household savers also fueled a bubble in local assets.

An artificially low currency fueled very rapid growth in the tradable goods sector while also constraining household income growth.

Because the growth model constrained growth in household income and household consumption, it forced up the domestic savings rate to extraordinary levels.

The combination of low consumption and excessive manufacturing capacity required a high trade surplus in order to balance production with demand.

And finally, and most worryingly, debt levels across the economy began to soar as debt rose much faster than debt servicing capacity.

All of this is true of China today, and this is why it is much more important to understand how Japan rebalanced after 1990 if you want to understand the challenges and risks facing China today. China is not like Japan in the 1950s, 1960s or 1970s in any meaningful way even if its current development level is much closer to Japan during those decades. Because of the serious imbalances China is much more like Japan in the late 1980s, with the major difference being that Japan never took debt, investment, and consumption imbalances to anywhere near the levels that China has taken them.

Ouch ... How, then, will the imbalances be reversed.

For this reason what we really have to consider when thinking about China is how these imbalances tend to be reversed. Since they were reversed in Japan in the period following 1990, Japan provides at least one possible model for China’s rebalancing process and, perhaps much more importantly, it demonstrates the kinds of pressures that China will face as it is forced into rebalancing. ...

What about Europe?

Economic growth in Europe over the next ten years ... will not be anything like economic growth in the last ten years adjusted for changes in demographics, taxes, or anything else. We will be dealing with a Europe in which the tremendous debt, currency, and labor cost imbalances of the past decade must be reversed, and since the most likely form of the reversal will entail the breaking up of the euro, any growth predictions that do not at least acknowledge this chaotic rebalancing process are likely to be flimsy at best.

Currently Paddy Power is offering odds for both the end of the Euro and for individual countries leaving the Euro. Interestingly Greece is not included. Too short or what? My prediction is for an exit during the Xmas-New Year period, if if indeed happens. It's possible of course that European policy-makers will do whatever it takes to keep the currency going. (In other words I'm not suggesting you take a bet!)

The problem for the world economy is that the credit-fuelled growth strategy prevalent in most of the world has to at best stabilise or keep reversing.

Likewise with predictions of US consumption growth, which will have to deal with reversals in the savings and consumer credit trends of the past decade, and with sharp change in two decades of housing behavior.

For Australia there is, at best, volatility ahead.

Predictions about the prices of hard commodities, which have to consider a major dislocation in the source of commodity demand since the early part of the last decade, are also likely to be highly unstable.

As Pettis points out economic predictions are very difficult.

If you want to make economic predictions, in other words, whereas a long historical view will be very useful because it allows you to consider the dislocations created by a reversal of unsustainable imbalances, recent economic data are largely useless, as are predictions based on linear adjustments of recent economic data. Instead of projecting from past data you must model the various paths by which rebalancing can occur, and your prediction must be limited to those paths.

Pettis gives relatively short shrift to the view that insights from neuroscience could make a difference in predicting economic events.

This suggests that we don’t really need a radically new understanding of economics. To understand the global rebalancing, or the European debt crisis, or the upcoming Chinese economic adjustment, we need only to read the works of John Maynard Keynes, Hyman Minsky, Charles Kindelberger, Friedrich Hayek, or dozens of other economists of the 19th and 20th centuries. In every case they fully understood how economies can beetle along in one direction and then suddenly, as imbalances become unsustainable, reverse course and follow a dramatically different path.

This is simply a logical outcome of disequilibria, and doesn’t require anything quite so mysterious as brainwave patterns or irrational behavior mechanisms to explain the process. I think it was Herb Stein, President Nixon’s economic advisor, who reminded us that "If something cannot go on forever, it will stop."

In other words, as Keynes was reputed to have said: the unsustainable cannot be sustained.

It would have been much more powerful, I guess, if Stein had expressed this idea in a way somewhat more mathematical and abstruse, but anyway it seems like a pretty good explanation of what has happened in the US and in Europe in the past few years and what will happen in China in the next few. Just because many economists fail to see the point doesn’t require an overhaul of the discipline – perhaps it only requires an overhaul of the way the discipline is taught.

Pettis then goes on to quote a number of news sources outlining some very bad news for Australia.

Copper inventories at bonded warehouses in Shanghai probably climbed to a record as import premiums dropped to a four-month low, signaling demand in China may not be improving as much as expected after a summer lull.

Reserves were 650,000 metric tons, according to the median of nine estimates from traders, analysts and warehouse managers, compiled by Bloomberg. Five said that this was a record. The amount compared with an estimate of 550,000 tons by Macquarie Group Ltd. on Aug. 20. Fees paid by importers over the London Metal Exchange cash price are about $40 to $60 a ton on a cost, insurance and freight basis, the lowest since May.

The southern Chinese province of Yunnan has launched a subsidy programme for metals producers, in a sign of the pain hitting the Chinese metals sector as demand growth remains low. Slowing economic growth in China, the world’s biggest consumer of commodities, has meant falling profits at Chinese raw materials producers, including copper smelters, steel mills and zinc smelters.

An official at the Yunnan Provincial Industry and Information Technology Commission confirmed that a small “stockpiling” programme, which has not been publicly announced yet, was launched in September and would continue until the end of the year. The programme targets copper, zinc, aluminium and other small metals, the official said.

Under the programme, which covers 300,000 tonnes of metals, producers will be able to draw subsidised loans from banks using their material as collateral. Banks will give the companies loans based on preset “purchase” prices for the commodity, and the Yunnan government will subsidise the process by paying for the interest on the bank loans. The system is designed to help smelters by providing them with more liquidity as financing gets more difficult. “The targets of this stockpiling system are the companies,” the government official explained.

But perhaps the inevitable pain could be delayed by more stimulus.

In Saturday’s South China Morning Post there was another article on roughly the same topic:

A group of state-owned Chinese shipping companies has placed a US$4.5 billion order for 50 supertankers, throwing a financial lifeline to struggling shipbuilders.

The order adds to a flurry of infrastructure investments by state companies in recent weeks - a key element in Beijing's effort to reverse a painful slowdown in economic growth. The government has approved a wave of spending on new steel mills, subway lines and other corporate and public works projects.

…Chinese shipbuilders, the world's biggest by tonnage, have been among the industries hit hardest in the slowdown. Orders have fallen by more than half, and shipyards are cutting jobs.

"Small and medium-size shipbuilding companies are either out of business or near bankruptcy," said Xia Xiaowen, an analyst for the China Shipbuilding Economy Research Centre, a think tank in Beijing. If the reports of new orders are accurate, "it will definitely be good news for those large manufacturers, and they don't need to worry about survival any more", Xia said.

But eventually, Pettis argues, rebalancing will have to occur.

no matter what analysts or policymakers may say, there is absolutely no way to resolve the problem of growing excess inventory except by abandoning the development model. Until China rebalances, in other words, it cannot resolve the problem of excess inventory because excess inventory is one of the inevitable consequences of the process that created the imbalances.